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Worrywarts last week got their first real taste of the market's reaction to Washington's fiscal cliff: a steep stock-market selloff. Investors drove the Dow Jones Industrial Average to a 313-point loss the day after President Barack Obama's re-election, a victory that fueled fears of Washington gridlock and more than $600 billion of automatic tax increases and spending cuts. But income seekers have something to cheer. Several popular dividend-themed exchange-traded funds weren't hit nearly as hard as the 2.4% decline in the blue-chip index.
Vanguard Dividend Appreciationvig -0.947808961102905%Vanguard Dividend Appreciation ETFU.S.: NYSE Arca80.47
-0.77-0.947808961102905%
/Date(1427835596002-0500)/
Volume (Delayed 15m)
:
816936AFTER HOURS80.47
-0.210000000000008%
Volume (Delayed 15m)
:
29
P/E Ratio
N/AMarket Cap
N/A
Dividend Yield
2.281595625699018% Rev. per Employee
N/AMore quote details and news »viginYour ValueYour ChangeShort position
(ticker: VIG), an income-investing perennial, dropped a less painful 1.8%. Sure, that's how "safe" stocks usually behave. But it was notable this time, since investors have been especially fearful of the fiscal cliff's dividend-tax increases. Far from a selloff focusing on dividend stocks, Wednesday's trading suggests that rich-yielding stocks may be relatively graceful cliff divers.

Make no mistake, investors have been bracing for dividend-tax increases. S&P Capital IQ strategist Sam Stovall has found that S&P 1500 sectors yielding 3% or more fell an average of 1.3% from the end of September to the week before the election, more than twice the decline in stocks yielding 1.5% to 3%. Meanwhile, the lowest-yielding stocks rose 0.8%. It was an indication that some investors were moving out of dividend payers just as fears of tax increases are taking root. Under the direst scenario—if Congress does nothing to soften automatic tax increases—the 15% federal dividend-tax rate could soar to 43.4% for households earning $250,000 or higher by Jan. 1.

But here's why the dividend fear may be overblown: Many owners of yield-oriented stocks are insulated from new taxes. WisdomTree Investments reported last week that only about 52% of qualified dividends went to tax filers earning $250,000 or more in 2009, the latest year for which figures are available. (Qualified dividends are those taxed now at 15%. That's all but certain to change with the fiscal cliff.) Also, the WisdomTree study points out that tax-insensitive retirement accounts hold over $7.8 trillion in equity assets. In all, that will sharply lessen the perceived impact of a dividend-tax hike.

In fact, qualified dividend income made up only 3.85% of wealthy households' total income, according to the WisdomTree study. "The market environment is more important than the tax environment. It's not as important as everybody fears," says Jeremy Schwartz, director of research at WisdomTree, a $17 billion ETF sponsor whose most popular products are dividend-themed ETFs.

The real danger for income investors may instead be the same one facing the entire market: automatic budget cuts and tax increases that take down all stocks to one degree or another. But even in that case, there's reason to think that low prices and richer yields will attract fresh buyers. You can bet that yield seekers will show up if these stocks go on sale.